Picket and pocket it

Fund manager 'on strike' against high-quality bonds

SAN FRANCISCO (CBS.MW) - Forgive shareholders of the FPA New Income fund for not understanding that bond mutual funds can lose money when interest rates rise.

Manager Bob Rodriguez hasn't lost a dime in a calendar year over the two decades he's managed New Income
FPNIX, +0.00%
the choosy, contrarian flagship from little-known First Pacific Advisors in Los Angeles. Even bond guru Bill Gross can't make that claim.

Now Rodriguez continues to shun the benchmark 10-year U.S. Treasury bond and other high-quality securities, a stance he adopted in early summer after becoming convinced that interest rates had become unrealistically low.

"We are on a buyers' strike," Rodriguez wrote shareholders in mid-June. "This is a bond market bubble that is quite similar to what too place in the equity market three years ago."

Days later, the yield on the 10-year Treasury began its rise from a low of 3.1 percent to its current 4.5 percent range. The shift has been harrowing for long-term bondholders, as prices move opposite to interest rates.

Still on strike, Rodriguez says he won't touch high-quality bonds until rates move even higher. Given signs of renewed strength in the U.S. economy, that potential is real, he ventures. He's also insulated New Income from rising rates with investments in some uniquely defensive securities.

Accordingly, Rodriguez is relatively optimistic about U.S. stocks, which he buys for his other fund, FPA Capital
FPPTX, +1.70%
a value-conscious small-cap portfolio.

Rodriguez spoke with CBS Marketwatch earlier this week about his bearish view of high-quality bonds and how much Treasurys will have to yield before he starts buying them again. And when he does, you can be sure his moves will be out of step with the market. Listen to interview with Bob Rodriguez

MKTW: You've drawn a line in the sand on the 10-year U.S. Treasury bond - a 'buyer's strike,' you said. What led you to shun high-quality bonds?

Interest rates during this past year and especially in June, as measured by the 10-year Treasury, had gotten to levels that were basically unsupportable by what was going on in the economy. One had to be extremely pessimistic about the economy, growth and inflation to be a buyer of the 10-year when it was down at the 3 percent level. We felt that the 10-year Treasury and other high quality bonds were pretty much devoid of any measure of real value.

MKTW: Are you still on strike?

We're still on strike. I fully expect to be on strike for some time. For the past nine months to a year we've basically argued that the fair value for the 10-year Treasury is somewhere in the five- to 5.5 percent range, not where it's at today.

MKTW: What is happening in the economy for you to value the 10-year at 5.5 percent?

The fundamental level of inflation in the United States is still in the two-, 2.5 percent range, and some extraordinary circumstances came together to push that number down.

Core numbers are still pretty much in the 2 percent range, and if you add in a 3 percent real inflation number -- 2 percent inflation and 3 percent real return -- that would get you into the 5 percent level.

MKTW: Going forward, what would this environment mean for high-quality bonds?

We still have further to rise in rates and that will be reflective of the timing and strength of the U.S. economy. That will have some type of an impact on interest rates, and especially high quality interest rates. The economy is going to be far stronger than most people expect.

MKTW: Under what conditions would you buy the 10-year Treasury?

Should yields on the 10-year move to the 5.25, 5.5 percent range, we would start to think about extending our maturities gradually. We would be looking at not necessarily Treasurys but other types of spread product where you would then get compensated additional return for taking on a bit of extra risk.

MKTW: So you foresee more pain for the bond market. But an improving economy would bode well for stocks and high-yield bonds.

We would think so. You've had a major rally in high yield bonds, along with a sizeable rally in the equity market. There's more room to run in the equity market due to the fact that we think we're entering a more speculative period.

That's also quite positive for high yield bonds, but given their spreads have come in so much, earning your coupon in high yield is probably as much as you're likely to expect at best.

Longer term, we have expressed a more cautious outlook on the equity market, which would dovetail with the high-yield market. That would be out more in the '05, '06 period.

MKTW: So a year from now you might expect to trim high-yield bond exposure.

Over the course of the next six to 12 months, we will be in a trimming mode -- or what we would say a 'risk reduction mode' -- in terms of credit quality.

MKTW: Where would you deploy your money then?

As the high quality segment of the bond market gets hit, and we're reducing our exposure to the high yield segment, we could see replacing credit risk with more interest rate risk. There are two different risks in the bond market: interest rate risk, the risk of interest rates rising and falling, and credit risk -- are you going to get your money back?

Over the course of the last year and a half, it has been really quite profitable to invest in the credit-risk area, more than in the interest rate risk area. We think that is going to start to change. It would lead us into high quality.

MKTW: Then you would go off-strike.

We would start to go off-strike. We tend to hide in our bond fund for long periods of time, and wait for periods where there is high level of pain and frustration.

It's very much a contrarian type of investment philosophy. That is what we've deployed over the last 20 years that my associates and I have been managing this fund, and it also reflects the fact that we have never had a down year in our bond fund and have avoided these negative interest rate environments. Over the long run, we've outperformed the bond market.

MKTW: FPA New Income does have flexibility in terms of the types of securities it can own.

We have a fair amount of latitude, but in the less-than-investment grade or less than AA area, our maximum exposure is 25 percent. So it is very much a high quality bond fund.

We've had as much as 25 percent invested in high yield and broken convertible bonds, and as low as 2 percent. On the high-quality side, over the last 20 years we've had duration considerably longer than our benchmark, the Lehman Government Corporate Bond Index.

This time around, at the trough of the bond market, duration - a measure of volatility - got down to 1.2 years, which was 50 percent shorter than the shortest duration we've ever had. In our opinion there was just no value, so why risk our shareholders' capital?

MKTW: Which high-quality bonds are attractive now?

We've got about 22 percent of the portfolio deployed in Treasury Inflation Protected Securities. They mature in '07, so we have a very short maturity there. Over the years TIPS have outperformed their companion nominal Treasury bonds. You've got more return with less volatility.

A second area in high-quality land has been the mortgage area, but not your typical mortgage. It's been in interest-only securities. Those are securities that rise in value when interest rates rise, and we started deploying those back in March of this year.

Initially they were painful to hold because the prices were going down quite rapidly, and in June we scaled in another tranche of I/Os. Some of these securities got down to such levels, they were assuming 5.5 percent mortgages were going to disappear in effectively one to two years. In order for that to occur, you had to have an extremely negative economic outlook and a very optimistic interest rate outlook.

That was totally at odds with us. We just did not see that as a high probability outcome and as a result of that we deployed a fair amount of money into that area. Some of those securities today are up upwards of 100 percent.

MKTW: You're far less optimistic about the bond market than many of your peers.

I grew up during a period of time where they referred to bonds as certificates of confiscation, during the inflation period. I find it fascinating that managers in general get optimistic about environments and what they're doing when there is risk in the marketplace.

We tend to run away from risk or certain types of risk when we do not deem it prudent to be there. You have to be willing to step away from the crowd if you expect to be a long-term survivor and achieve better than average investment returns.

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